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Can you use the variance ratio test to determine whether or not a time series is mean reverting? I'm using the Lo.Mac function in the vrtest library in R.

I've used the test to reject geometric Brownian motion as a price process. Does that indicate that I have a mean reverting process or does it only indicate that the assumptions of geometric Brownian motion are not satisfied?

My plot of variance ratios looks like this: enter image description here

I don't quite understand the interpretation of this plot!

Note: I don't want to use a unit root test for stationarity because the process has nonconstant variance. It is not second order stationary although I believe that it is mean reverting.

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2 Answers

up vote 6 down vote accepted

It only indicates that the null hypothesis of uncorrelated increments is violated.

For the sake of simplicity, assume a time series is stationary. Then a sufficient statistic for arbitrary variance ratios is its covariance function. In general, a given deviation from the null can originate from different covariance functions, which in turn, entails that making any specific claim about mean reversion is not trivial. I find that this point is often overlooked in the financial literature. I expect that when phrased properly a similar statement can be made about non-stationary series.

That being said, mapping abnormal variance ratios to mean reversion/trend following is not impossible but it requires making specific assumptions about the alternative model.

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I tend to agree with you. However, I found the following quote: "The mean values of the individual firm variance ratios are shown in Table 5. They suggest some long-horizon mean reversion for individual stock prices." Page 19 of albany.edu/faculty/faugere/PhDcourse/meanreversion1.pdf I'm having trouble understanding why certain variance ratios would imply mean reversion. –  wcampbell Apr 5 '13 at 18:02
    
In the abstract of the same paper: "It demonstrates that variance ratios are among the most powerful tests for detecting mean reversion in stock prices." –  wcampbell Apr 5 '13 at 18:05
    
I updated my answer to address some of your comments. –  Ryogi Apr 5 '13 at 18:10
    
Ok, I'm satisfied now. Thanks! –  wcampbell Apr 5 '13 at 18:15
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of course you can use this test to elaborate on this matter. Basically this test measures the ratio of variance of series in period tn to n*variance of t preriod

$\frac{Var(tn)}{nVar(t)}$

in short:

  • constant ratio for random walk
  • increasing for series with trend
  • decreasing for mean reverting process, more decreasing (faster) - better mean reversion

enter image description here

enter image description here

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